Compelling reasons to keep small caps

But US smaller companies in particular bucked this environment to post compelling returns into the year-end. While some investors question how long the small-cap rally can continue, there are a number of reasons to maintain or increase an allocation to small caps in 2017.

Arguably the most significant political event of the past year was the surprise election of Donald Trump in the US. While markets initially wobbled, Mr Trump’s proposed fiscal stimulus helped to lift growth expectations, buoying investor sentiment. In the days following the election, the Russell 2000 index of small cap names had its longest stretch of consecutive market gains since June 2003. 

However, this success should not be attributed to the Trump effect alone. Improving US economic data over the past year, such as GDP growth and employment data, helped strengthen the case for the Fed to raise interest rates 0.25 per cent in December and begin its move to ‘normalisation’, setting the pace for other central banks around the world. These encouraging economic indicators also prompted the broader rotation into risk assets witnessed in the second half of last year.

At the global level, smaller companies rose 12.7 per cent according to the MSCI World Small Cap index, outperforming the large and mid-cap MSCI World index, which rose 7.5 per cent, led by small-cap outperformance in the US and Japan.

This was largely driven by a reversal of fortunes in the energy, industrials and materials sectors as commodity prices stabilised into the latter half of 2016. While the Brexit vote sparked some risk aversion in Europe mid-year, UK small caps subsequently rallied, with the FTSE Small Cap index rising 16.6 per cent from July to the end of December, whereas the FTSE 100 index rose 11.7 per cent over the same period.

Far from assuming that 2016’s small-cap rally has run its course, investors would be wise to consider the positive long-term benefits of a structural allocation to smaller companies. While uncertainty remains at the political level, motivated small caps will likely be undeterred from creating innovative products.

There are three potential themes for the year ahead:

Rising interest rates could lift small-cap fortunes. Overall, a rising rate environment should produce a positive tailwind for global small-cap investors, particularly given the historic strong correlation between European small-cap stocks and the 10-year US treasury yield in terms of performance. The combination of higher interest rates and inflation expectations also appears to have lifted corporate earnings expectations, which should help deliver on valuations.

While a greater policy focus on inflation could lead to higher potential for materials and related sectors, investors should also exercise caution should an excessive deflationary impact on household income reduce consumer spending. In the US, Mr Trump’s proposed fiscal spending should lift small-cap fortunes, as they typically generate a much higher proportion of their earnings domestically than more international large caps.

Small caps will be attractive M&A targets. Smaller companies have long been a key beneficiary of M&A activity as large companies look to expand in periods of low growth – and 2016 was no different. While M&A activity fell 16 per cent from 2015’s bumper year, 2016 was still the third-strongest annual period for global M&A since records began in the 1980s.

Interestingly, global cross-border M&A rose to an eight-year high, demonstrating the desirability of smaller local businesses to larger groups. Looking ahead, currency movements could sweeten the deal for overseas buyers as a weaker pound could make UK companies more attractive.

Global small-cap opportunities remain. Developed market small caps are under-researched and, therefore, under-owned, relative to large caps. In emerging markets (EM), the even greater scarcity of analyst coverage could also be an area of untapped opportunities. Investors with the resources to exploit market mispricings could, therefore, benefit from improving standards of reporting in small EM companies.

While political uncertainty is likely to continue in 2017, there are many reasons for optimism. Overall, selectively chosen small caps should maintain their ability to grow their earnings independently of the macroeconomic environment and remain desirable for some years to come.

Matt Lovatt is global head of business development at Axa Framlington